Seize the day before regime change mess

Focus on recovery All that Raghuram Rajan has to do is abandon the belief that raising interest rates is the cure for all types of inflation. Photo: AFP

The 2014 General Election is less than six months away. Therefore, the Manmohan Singh-led UPA government has, at most, eight weeks in which to take economic policy decisions that can end the country’s four-year recession before the time for decision-making expires. In concrete terms, this means the end of December. Since this is also when the Reserve Bank of India (RBI) will present its next mid-quarter policy prescriptions, it means that the ball will land squarely in Raghuram Rajan’s court.

In his three months as the RBI governor, Rajan has made three important policy statements. All of them have shown a fixation upon controlling inflation. In none has he shown the slightest concern for growth. His second-quarter policy statement on 30 October is the most explicit. In it, he comes within a hair’s-breadth of saying that growth is not a goal to be pursued for its own sake. It will happen automatically when the government sets everything else right.

At the head of his list is inflation. Rajan believes in an “activist” monetary policy, i.e. in one that keeps the nominal rate of interest higher than the inflation rate. So, to the industry’s intense disappointment, he has continued with his two predecessors’ high interest rate policies.

When Rajan took over as the RBI governor in September, this was not unjustified. The exchange rate was in free fall and panic was spreading like a poisonous gas through the Indian and foreign investors’ community. Therefore, it was not the right time for a drastic change in policy.

But this dark moment has receded into the past. The exchange rate has stabilised; the panic-driven interest rates of 16 July have been brought down in line with the RBI’s other policy rates. Foreign investors are coming back, gingerly, to the Indian market and the foreign exchange reserves have begun to rise. If the rupee is still depreciating marginally, it is by design, because Rajan is impounding the foreign exchange inflow taking place on the capital account to raise India’s foreign exchange reserves instead of letting it flow into the economy.

But the economy is not out of danger. The Federal Reserve has only postponed the tapering off of its fiscal stimulus programme in the US. And there is a far blacker cloud on the horizon: More than 200 of the largest and most reputed companies in the country, which issued convertible debentures in the international market six years ago, are unable to convert them into shares because of the 40 percent depreciation of the rupee since 2007 and the sharp decline in share prices since 2008.

Thus, India faces the biggest collective default on private international commitments since the East Asian meltdown of 1997. Should this default occur, the shock will cause an exodus of foreign investors, which will plunge the country into a foreign exchange crisis of 1991-dimensions once more.

The only development that can fend off both of these threats is a sharp, broadbased and sustained recovery in share prices. And the only thing that can bring this about is the long-awaited sharp cut in interest rates. A lowering of repo rates and the cash reserve ratio will force commercial banks to cut their deposit and lending rates.

The first of these will start a shift of savings out of bonds and bank deposits into shares, thereby triggering a rise in their prices. The second will revive borrowing, first for consumption, then for purchasing homes, and finally for investment. Rising share prices will neutralise the pull on foreign institutional investors (FIIs) of rising bond prices in the US when the Fed begins to tapers its fiscal stimulus programme. But more importantly, it will allow most of the debenture-issuing companies facing default and catastrophe abroad to fulfil their conversion commitment and allow the rest to ask, credibly, for a little more time.

In the real world that obstinately refuses to conform to the Chicago school dogma, the only risk India would run by lowering interest rates is of the rise in imports that will follow the revival of demand. This risk seemed very real in June and July when the Current Account Deficit (CAD) was running at 4.9 percent of the GDP, foreign exchange reserves were falling, and the Federal Reserve’s announcement that it would phase out its fiscal stimulus programme was sucking FIIs out of India into the US bond market. But it has almost completely disappeared now. The Fed has postponed its phase-out; NRI money has flowed into the country under two new schemes announced by the RBI, FIIs has begun to return to the share market and foreign exchange reserves have at last started to rise.

Best of all, a close examination of the trade data shows that India’s CAD is about to vanish. Exports are rising at 11-13 percent and imports have fallen sharply. The trade gap has narrowed in the first half of 2013-14 (April-September) by just under $12 billion. This has led Finance Minister P Chidambaram and others to predict that the CAD will fall from $88 billion last year to around $60 billion this year. But this estimate is too pessimistic.

The first half’s figures have been distorted by a huge speculative import gold, worth $15.45 billion, in April and May. Since June, the trade deficit has averaged $10.7 billion against $15.7 billion in 2012. If this trend is maintained, the 12-month deficit, measured from June to May instead of April to March, will be in the neighbourhood of $128 billion. If the net services income from abroad stays at last year’s $108 billion, the CAD will shrink from $88 billion in 2012-13 to $20 billion. This is just about 1 percent of the GDP. In fact, if the rise in exports continues, it will be even smaller.

Therefore, India has an ample and growing cushion to absorb the rise in imports that precedes the revival of growth. There is no downside to lowering the interest rate now. All that Rajan has to do is abandon the belief that raising interest rates is the cure for all types of inflation; recognise that India is suffering from endemic cost-push inflation born of supply shortages, and that the only cure for these shortages is economic growth.

In December, the UPA government will have one last golden chance to turn the economy around without running any risk. If Rajan chooses not to seize it, in the belief that he can wait for the new government to be formed, he could not be more naive. Because there is only one certainty about the next government: that it will not give either the Congress or the BJP enough seats to form a stable government. Because the Congress is certain to lose a large number of seats, and the formation of another NDA government under Narendra Modi’s leadership looks doubtful.

If the political uncertainty is prolonged, FII, and perhaps NRI, deposits too will leave the country in a rush. Rajan will then have no option but to keep up interest rates. India’s near-zero industrial growth will get prolonged indefinitely. After that, an economic crash will become inevitable.

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